What is collateral?
Collateral is necessary for any secured loan. Collateral is any asset or property that a borrower pledges as security for a loan and serves as a guarantee to the lender that they will recoup their losses if the borrower cannot continue monthly payments on a loan. In the case of a business loan, collateral can be in the form of real estate, inventory, accounts receivable, or any other valuable asset that the lender deems acceptable.
Collateral is important in securing a business loan because it reduces the lender’s risk and increases the likelihood of loan approval. By offering collateral, the borrower demonstrates their commitment to repayment and provides the lender with a means of recovering their investment if the borrower defaults.
Lenders typically require collateral for larger loans or loans with higher risk profiles (though there are several types of alternative business financing that allow for funding without collateral). The inclusion of collateral typically allows startups and businesses with lower credit scores to receive funding at low interest rates compared to those they’d pay on an unsecured loan.
Forms of collateral used in traditional loans include:
Real estate: Commercial property or personal property, such as a home, can be used as collateral to secure a business loan.
Inventory: Physical goods owned by the business, such as raw materials or finished products, can be pledged as collateral.
Accounts receivable: Outstanding customer invoices can be used as collateral, which is known as accounts receivable financing.
Equipment: Machinery or other business equipment can be used as collateral. (When a loan is given to purchase equipment which is, in turn, held as collateral on that loan, that is known as an equipment loan).
Securities: Marketable securities, such as stocks or bonds, can be used as collateral for a business loan.
Personal guarantees: Personal assets or credit can be used as collateral if the business owner guarantees the loan with their own assets.
These forms of collateral have been traditionally used by banks and other financial institutions to secure business loans and offer lower interest rates. But with the rise of cryptocurrency, it is becoming more common for businesses to use digital assets as collateral.
What is cryptocurrency?
Cryptocurrency is a digital or virtual currency that uses cryptography for security and operates independently of a central bank. Cryptocurrencies are decentralized and operate on a peer-to-peer network, meaning transactions are verified by users on the network rather than a central authority.
Crypto has made massive gains in popularity in the last decade. The United States Small Business Administration is even hosting webinars and other resources for accepting payments and accounting with crypto.
The following are the key characteristics of cryptocurrency:
Decentralization: Cryptocurrencies operate on a decentralized network, meaning no central authority controls transactions. Instead, transactions are verified by users on the network. Crypto is sometimes known as decentralized finance or DeFi.
Transparency: Transactions on a cryptocurrency network are publicly visible and recorded on a blockchain digital ledger.
Security: Cryptocurrencies use complex cryptographic algorithms to secure transactions and prevent counterfeiting.
Limited supply: Most cryptocurrencies have a finite supply, meaning there is a cap on the number of units that can be created.
Volatility: Cryptocurrency prices can be highly volatile, meaning they can experience significant fluctuations in value over short periods of time.
Pseudonymity: Transactions on a cryptocurrency network are not linked to a user’s real-world identity but are associated with a digital address.
Accessibility: Cryptocurrencies can be bought and sold online, and transactions can be made quickly and easily across borders.
Many of the above traits of cryptocurrency are also reasons that financial service companies are sometimes leery of them. They’re anonymous, volatile, and thus less predictable than dollars. They could also be theoretically be used to circumvent certain financial regulations involving industries like cannabis.
The three most popular types of crypto by market capitalization are Bitcoin, Ethereum, and Binance Coin.
Bitcoin (BTC): Bitcoin is the first and most well-known cryptocurrency. It was created in 2009 and operates on a decentralized blockchain technology network. Bitcoin is designed to function as a store of value and a medium of exchange.
Ethereum (ETH): Ethereum is a blockchain-based platform that enables developers to create decentralized applications (dApps) and smart contracts. It operates using Ether, which is used to pay for transactions and power dApps on the Ethereum network.
Binance Coin (BNB): Binance Coin is a cryptocurrency that is used to pay fees on the Binance exchange, one of the world’s largest cryptocurrency exchanges. It was created by Binance and has gained popularity due to its use in reducing trading fees and gaining access to other services on the exchange.
Each of these cryptocurrencies has its own unique characteristics and use cases. Bitcoin is often used as a store of value, while Ethereum is used for building decentralized applications and smart contracts. Binance Coin is primarily used within the Binance exchange ecosystem. However, all three cryptocurrencies are widely traded and have gained significant attention from investors and businesses.
The current state of cryptocurrency collateralization
Using cryptocurrency as collateral for loans is a relatively new practice, and its acceptance and availability vary among financial institutions and lending platforms. However, the emerging trend of using cryptocurrency as collateral is growing due to digital assets’ increasing popularity and potential benefits.
It should be noted that the use of cryptocurrency as collateral is different from crypto lending, in which business or personal loans are carried out entirely with digital currencies. Crypto loans are also an emerging area of interest for many financial institutions.
Several financial institutions and lending platforms now accept cryptocurrency as collateral for loans. For example, companies such as BlockFi, Celsius Network, and Nexo offer loans backed by cryptocurrency collateral. Additionally, traditional financial institutions such as Silvergate Bank and Signature Bank have also begun to offer loans backed by cryptocurrency collateral.
Using cryptocurrency as collateral offers certain advantages over traditional forms of collateral. Cryptocurrency collateral can be transferred instantly and does not require physical verification or appraisal, making the lending process faster and more efficient. Additionally, cryptocurrency collateral can be easily moved across borders, which can be beneficial for businesses with global operations.
However, the use of cryptocurrency as collateral also presents certain challenges. One of the primary concerns is the volatility of cryptocurrency prices, which can result in significant fluctuations in the value of the collateral. Digital currency isn’t like the U.S. dollar: the price of crypto can fluctuate wildly. Additionally, there is still a lack of regulatory clarity surrounding cryptocurrency, which can lead to uncertainty for lenders and borrowers alike.
For that reason, lenders allowing for crypto collateral sometimes require as much as 50% loan-to-value ratios (LTV). The loan-to-value ratio compares the value of a collateralized asset to the size of the loan. That means to acquire a loan amount of $10,000 USD, you’d need to put up $5,000 worth of crypto.
Overall, the use of cryptocurrency as collateral for loans is an emerging trend that is gaining popularity. As the use of digital assets becomes more widespread, it is likely that more financial institutions and lending platforms will begin to accept cryptocurrency as collateral, which could lead to further innovation in the lending industry.
The Risks of Crypto Collateral
Using crypto collateral presents several risks that borrowers and lenders should be aware of before they agree to loan terms. Here are some of the key risks associated with using cryptocurrency as collateral:
Price volatility: One of the primary risks associated with using cryptocurrency as collateral is its high price volatility. Cryptocurrency prices can fluctuate significantly over short periods of time, which can result in the value of the collateral dropping below the amount of the loan.
Lack of regulation: Cryptocurrency is still a relatively new asset class and there is a lack of regulatory clarity in many jurisdictions. This can create uncertainty for lenders and borrowers, particularly in regards to the legal status of cryptocurrency and the rights of creditors in the event of default.
Cybersecurity risks: Cryptocurrency is a digital asset and is susceptible to cybersecurity risks, such as hacking and theft. If a borrower’s cryptocurrency is stolen, it can impact the value of the collateral and potentially result in default.
Liquidity risks: Cryptocurrency markets can be illiquid, meaning it may be difficult to sell the collateral in the event of default. This can result in delays or losses for lenders seeking to recover their investment.
Technical risks: Cryptocurrency is a complex and technical asset, and borrowers may not fully understand the risks and technical aspects of using cryptocurrency as collateral. This can lead to misunderstandings or errors that can impact the value of the collateral.
Advantages of using cryptocurrency as collateral
Using cryptocurrency as collateral for a business loan offers several advantages over traditional forms of collateral. Here are three advantages of using cryptocurrency as collateral:
Speed and efficiency: Cryptocurrency can be transferred instantly and does not require physical verification or appraisal, making the lending process faster and more efficient. This can be beneficial for businesses that require access to funds quickly.
Accessibility: Cryptocurrency can be easily moved across borders and is not subject to the same geographical limitations as traditional forms of collateral. This can be beneficial for businesses that operate globally or have international partners.
Lower costs: Using cryptocurrency as collateral can be less expensive than traditional forms of collateral, as it does not require physical storage or transportation. Additionally, because cryptocurrency is a digital asset, it may be easier to verify and track, reducing the risk of fraud and lowering administrative costs.
